SaaS Due Diligence: 4 Areas To Cover Before Acquiring A Software Company
If you are an investor or aggregator who is considering buying a SaaS (Software as a Service) business, you probably know the importance of thorough due diligence. After all, the due diligence process is necessary in order to ensure that you are making a sound investment. While due diligence is usually one of the last steps before you acquire the business, in some ways, it’s the most important.
When it comes to SaaS businesses, there are several key areas to focus on during the due diligence process. Some overlap with other business models, and some don’t. In this post, we’ll cover each of these areas in detail. That way, you know what to look for before you acquire the business.
The first thing we’ll cover is accessing the market in which the SaaS business operates. This includes understanding the size of the market, the competition, and the trends that may impact the business. This is something you need to do with any business, no matter the model.
To get a sense of the market size, you should review industry reports as well as conduct market research to identify the total addressable market (TAM) for the business’s product or service. The TAM represents the total revenue opportunity for a product or service in a given market. This will give you insight into what the playing field is really like.
It’s also important to understand the competition in the market, including direct and indirect competitors. Look at the competitive landscape to see how the business compares in terms of pricing, features, and customer satisfaction. Consider whether the business has any competitive advantages that could help it stand out in the market. It’s not a bad idea to ask the seller questions about this, but obviously, you also want to conduct your own research.
Finally, you’ll want to review the trends in the market to get a sense of the direction in which it is heading. This can include things like shifts in customer demand, changes in technology, and regulatory developments. This is where SaaS businesses can vary from other business models, and also depends heavily on the industry.
Next, we’ll look at the finances of the company. This is a big one, as the financial health of a SaaS (or any) business is critical to its long-term success. Reviewing and analyzing the company’s financials is a crucial component of the due diligence process, as it can help you understand the business’s stability and growth potential.
Coming into an acquisition, the main question buyers want to know is, “Is this business worth what the seller is asking for?”
It’s usually a good idea to rebuild the founder’s P&L (profit and loss) statement from scratch. During due diligence, you’ll get access to all of the business’s tools and back-end software, so you can take their inputs to create your own P&L. Then, you can compare yours with the founder’s to identify any discrepancies. We follow this process at Centurica and we find it most effective at uncovering any discrepancies. Sure, it’s a lot of work, but it’s certainly worth it.
Once you’ve verified the P&L, you need to look at the customer acquisition cost (CAC) and customer lifetime value (CLTV). Make sure that the CLTV is higher than the CAC or you’ll likely face some cash flow challenges and perhaps not even be profitable. It’s a good idea to look for trends in the financials over time, as well as any red flags that may indicate financial challenges or risks.
It’s also vital to consider the company’s pricing model and customer acquisition costs. For SaaS businesses, the recurring revenue model can be a key driver of long-term growth and an attractive asset for buyers. So, you need to look at the company’s customer churn rate and the lifetime value of its customers to get a sense of the revenue streams. Is it sustainable? Is the churn higher than the industry averages? Churn is critical to SaaS due diligence since it indicates how much the customers like the product and how long they stick around for.
If customers are dissatisfied, they’ll cancel their subscriptions. It’s as simple as that. If they like the product and are happy, they’ll tend to stick around and continue paying. The higher the churn, the faster the customers drop off, and the more you have to spend on marketing to acquire new ones.
SaaS businesses are indeed software businesses, so you need to know that the software you’re acquiring is technically sound. This means that the technology must be clean, reliable, and functional. You need to make sure (it’s probably wise to hire an expert if you don’t know what to look for) that the tech is robust and efficient. Otherwise, you may be in for some surprises that lurk behind lines of sloppily-written code.
Here are some key considerations for SaaS companies when it comes to technology due diligence:
Do you understand the company’s product roadmap? What is their long-term vision and plan for technology development?
Look for a clear, well-defined roadmap that aligns with the needs of the market and the company’s competitive position.
Technical debt refers to the accumulated backlog of technical work that needs to be done in order to maintain or improve a product.
Is there a large amount of technical debt? Is there a lot of technical fixing needed or is everything running smoothly?
High levels of technical debt are surely red flags, as they can impact the company’s ability to develop new features or scale the business. How you handle the technical debt is up to you, but you definitely want to know what you’re getting yourself into and have an action plan.
How is the company’s hardware and software infrastructure? Can it support the needs of the customers?
Answers to these questions include examining things like the company’s servers, data storage, and networking equipment.
What are the data security policies in place? How does the company protect customer data?
In the age of data breaches and cyber threats, data security has become a top concern for SaaS businesses. So, you’ll need to review the company’s data security policies and practices to ensure that customer data is being adequately protected.
As a SaaS business grows, it’s very important that its technology is able to scale along with demand. You must consider the company’s current and projected growth, and assess whether its technology infrastructure is able to support it.
For example, I know of a company that was growing like crazy and was recently acquired. But, whoever did the technical due diligence missed a few things. So, as this software business scaled, the product began to have some serious problems. The acquirer ended up having to rebuild the product completely. As you can guess, this was very expensive and time-consuming.
Is it simple and/or possible to integrate systems and applications? If the SaaS company has integration capabilities with other systems and applications, it is important to review and assess it.
This includes reviewing the APIs, integrations with other systems, and the overall integration strategy. It’s important to know that the integration capabilities align with the business needs and will support future growth otherwise you’re likely in for a huge headache down the line.
Is customization an option? How easy it is? Depending on the nature of the business, it may be necessary to assess the customization capabilities of the SaaS company. If not now, maybe someday in the future. This includes the ability to tailor the product or service to specific customer needs, as well as the ability to add custom features or functionality.
As you can see, many of these components influence each other. For SaaS companies, technology due diligence is a crucial part of the due diligence process. But if you know what to look for, it can be pretty simple. By thoroughly reviewing and examining the technical aspects of a SaaS business, buyers can know what to expect. Remember, it’s not about getting the “perfect” business with no flats. The due diligence process is more about knowing what business you are getting so you can have an appropriate execution plan.
The final area of due diligence we’ll cover in this post is operations. This includes management, leadership, and how the company runs internally. Management and leadership play a significant role in a business and in its success.
You’ll need to review the company’s leadership team and consider factors such as their experience, track record, and vision for the company. You’ll also need to know what changes lie ahead.
For this, you need to consider the transferability risk. Transferability is rather simple: Are you and your team able to take over this business and run it effectively? Here are a few things to look for that can help determine the answer.
Key Person Risk Dependency: Is there one person who’s been running the business who has unique knowledge about the business? Could the business run without this person?
Vendors/Partners: Will the vendors and partners continue to work with you? Lots of smaller businesses don’t have partnerships or written contracts, so this is important to look into.
Team Members: Is the entire team coming with the business? Are they interested in working with you if you become the new owner?
Technical Niche: Do you and your team have the technical chops and skills to run this business?
Investing in Thorough Due Diligence Pays off in the Long Run
This post should give you a glimpse into what to look for before you buy a SaaS company. Remember, the due diligence process is about painting an accurate picture of what the business actually looks like and how it operates.
Just because you bump into a few red flags doesn’t mean that the deal is off. If you spot something concerning, you do need to take it into consideration, plan accordingly, and communicate with the seller.
The due diligence process can be complex and time-consuming, but it is essential to ensure that you are making a sound investment. If you thoroughly evaluate the market, financials, technology, and operations of the company, you’ll be able to make a better buying decision.
If you have an upcoming acquisition, SaaS or otherwise, consider seeking out the services of a professional due diligence provider like Centurica. Centurica specializes in providing premium due diligence services to businesses of all types, including SaaS companies.
And if you’re searching for the perfect SaaS business to suit your needs, look no further than the Empire Flippers marketplace. You’ll find a wide variety of high-quality SaaS businesses on offer to help you advance your entrepreneurial journey!